HONG KONG A foreign investor has moved to sever ties with Mongolia's largest private lender, Golomt Bank, because of its concerns over the lender's weak corporate governance standards, according to documents and a source familiar with the matter.

The Abu Dhabi Investment Council (ADIC), which lent Golomt $25 million in 2010, is seeking to call in the loan after a turbulent 15 months inside the bank, in which auditors identified serious management failings, according to the source and an external audit report reviewed by Reuters.

ADIC and Golomt are currently in dispute over whether the sovereign investor can redeem its five-year loan before maturity and the matter has gone to confidential arbitration proceedings in London, the source said, declining to give details.

ADIC's accusations of mismanagement inside Golomt, which holds a quarter of Mongolia's deposits, underline wider concerns voiced by credit rating agencies and the World Bank in recent months about poor corporate governance among the nation's banks.

The original loan agreement signed by Golomt and ADIC, an investing arm of the Abu Dhabi government, came amid a surge of foreign interest in Mongolia and its mineral wealth, which in turn spurred strong growth in bank lending.

Golomt Bank declined to comment.

ADIC's falling-out with Golomt began in 2012 when Japan's Itochu Corp (8001.T), a maker of mining and construction equipment, sued the bank for $43 million that Itochu said it was owed under letters of credit issued by Golomt in 2007 and 2008.

Letters of credit are a form of bank guarantee to facilitate trade. In this case, according to Itochu, Golomt guaranteed to pay Itochu on behalf of a Golomt client - Mongolian gold miner Altan Dornod - for the purchase of equipment from the Japanese firm.

The equipment purchases turned out to be faked, according to Itochu's version of events, as part of a scheme hatched by Altan Dornod and Itochu's own Mongolian sales manager to siphon money from the Japanese firm to the then Russian-owned mining firm.

The miner's owner at the time, Sergei Paushok, denies fraud took place and the former Itochu manager could not be reached for comment. Itochu has only given an outline of the alleged fraud in its public disclosures and many details remain unclear, including what, if any, benefit the sales manager obtained.

Itochu declined to comment.

For ADIC, though, the main issue was not about Itochu's allegation of fraud. Indeed, Golomt Bank appeared not to know about the alleged fraud at the time the LCs were issued, according to an independent investigator's report commissioned by the bank's board. Rather, it was that the bank had given such large guarantees - exceeding its entire share capital at the time - to Altan Dornod, without consulting the bank's board, the source said.

The size of the guarantees created internal uproar about how the LCs - in breach of central bank limits on single-customer exposures - could have been issued without triggering alarm bells inside the bank and without escalation to board level.

An investigative auditor, Dubai-based FSI Capital, probed the matter on behalf of Golomt's board in late 2012 and in December of that year recommended internal checks and balances be introduced - recommendations that, according to ADIC in April 2013, had still not been adopted.

It was then that ADIC took its director off the board.

"We feel we have no alternative given the board and management's unwillingness to co-operate with us to raise the bank's standards to a level consistent with what we set out to help Golomt Bank achieve," ADIC director Mark Cutis wrote in a letter to the central bank explaining his resignation.

The Bank of Mongolia, the central bank and the banking supervisor, declined to comment.

BANKING ON A MINING BOOM

The LCs controversy led to the delay of Golomt's published 2012 accounts - an event that ADIC said breached the terms of its convertible loan to the bank and triggered ADIC's demand for early repayment. The delay also led Moody's to withdraw its credit rating on Golomt and for Standard & Poor's (S&P) to suspend its rating. S&P cited "internal disagreement over Golomt Bank's corporate governance issues" for the suspension.

FSI Capital, which interviewed Golomt managers for its investigation, said the bank's credit committee had argued the LCs never put the bank at risk of a loss. The FSI report quoted a committee member as saying this assessment was based on an assurance given to Golomt by the Itochu sales manager that the Japanese company would never call on the LCs.

FSI director Stephen Price, who prepared the report, questioned the credit committee's explanation, saying that such an assurance from a relatively junior Itochu official should have raised red flags with the committee. Itochu has said its sales manager acted without head-office authorization.

The FSI report concluded that the committee, acting with questionable ethics, had accepted the Itochu manager's assurance out of a desire to charge a $1 million fee for issuing the LCs.

"The reasonable conclusion that can be reached by an objective examination of the facts is that the credit committee's decision was swayed by the opportunity to make fees and commission in excess of $1 million off the back of a set of transactions that would require very little effort ... and no capital, given the bank's decision to treat these LCs as 'risk free'," the report said.

OTHER FOREIGN INVESTORS

Golomt has three other foreign investors: Credit Suisse, which lent $10 million to Golomt in 2007, as well as Swiss-Mo Investment Ag, which has a 10 percent stake in the bank, and Dutch trading firm Trafigura which has a 5 percent stake.

Credit Suisse has also sought to call in its loan to Golomt, according to legal correspondence dated last September. But it is unclear if this move was also related to the LCs controversy or if Credit Suisse has been successful.

Credit Suisse declined to comment.

Swiss-Mo, which is controlled by Swiss financier Urs Schwarzenbach, and Trafigura both declined to comment.